Inflation is going away for a while

For a decade, starting in the mid-1990s, the Federal Reserve kept interest rates too low and expanded the money supply too quickly. Their theory was that, as long as consumer prices were stable, they must not be creating too much money. We now know that they were wrong.

Confused by the way globalization held down consumer prices, the Fed printed us up a metric truckload of inflation. It showed up in house prices, stock prices, oil prices, grain prices--pretty much all prices except the prices of stuff made in low-wage countries and imported into the United States. Unfortunately, those prices are a major component of the CPI--and particularly of the "core" CPI (consumer prices excluding food and energy).

Starting in late 2006 and accelerating in late 2007, though, that inflation started spilling into consumer prices as well.

The US (both the government and individuals) had borrowed huge amounts of money. Between that and the rising inflation, holders of dollars were beginning to think that maybe they didn't want all their cash in dollars. That put downward pressure on the value of the dollar, which pushed up the prices of just about everything (because the US imports just about everything). Prices soared--oil, wheat, milk, corn, anything traded globally got more expensive: This was a decade of excessive money creation by the Fed finally showing up in prices.

Just as this was happening, though, the Federal Reserve seemed to lose its mind. Instead of raising interest rates to curb inflation, it started cutting rates. Pointing to the "core" rate of inflation, which barely budged, the Fed suggested that deflation was a bigger worry than inflation.

The verdict is still out on that, but there's some new evidence that the Fed is right.

First, prices of global commodities are falling. In just the past few months:

So, what's going on? There are several forces at work, and they're currently feeding back into one another.

US as a safe haven

The same people who had decided that, in view of the US trade deficit and budget deficit, they didn't want to hold so many dollars have changed their tune. If the economy is going to melt down, maybe the US isn't such a bad place to have some wealth. The US has a strong tradition of sound banks and other financial institutions. In addition, it has seemed much more willing these past few weeks to take aggressive action to protect its financial system than some other countries.

With more demand for the dollar, it has been rising against foreign currencies. A stronger dollar means lower dollar prices for global commodities.

Leverage

During the huge spike in commodities, many investors piled on, trying to make money on what was obviously a long-term upward trend. Many of them did so with borrowed money--and many thought that the dollar would be the cheapest currency to borrow, because dollar interest rates were low and the dollar was falling.

Now, with the dollar rising, many of those investors are moving to unwind those transactions--selling their commodities so they can pay off their dollar debts now, before the dollar moves even higher. That pushes commodities down and the dollar up.

Economic slowdown

Less business activity means less demand for basic commodities, leading directly to lower prices.

Producers of basic commodities will obviously see lower profits. Other businesses are facing lower profits as well, even though some of their inputs are shaping up to be cheaper, simply because of falling demand due to the general economic slowdown.

Notice that these forces emphasize one another--any sort of economic stress makes the safe-haven aspect of the US look more attractive, anything that makes the US look more attractive raises the value of the dollar, and a higher dollar pushes down the price of commodities, producing more economic stress, and so on.

What about inflation?

I think there's a long-term trend toward higher commodity prices, simply because rising demand inevitably runs up against limited resources--oil, fresh water, arable land, etc. Because of that, I think declines in commodity prices are going to be temporary. Even so, prices might stay down for a considerable period, if the economy remains stressed for a considerable period.

I was one of those who, a few months ago, thought the Fed had lost its mind. Cutting interest rates just as inflation was spiking up to generational highs seemed like exactly the wrong policy. I've changed my mind. I certainly don't know if the Fed's policy is the right one, but I no longer think it's an insane one.

Vast amounts of "money" have simply disappeared: the illusory wealth of the housing bubble, the mortgage-backed securities based on it, and the paper assets based on those. The destruction of that "money" is hugely deflationary. The Fed is trying to create enough money to offset that destruction. The problem is that they have no way to know how much money to create. They're walking a tightrope, with a deflationary depression on one side and hyperinflation on the other.

The Fed is clearly inclined to err on the side of inflation, simply because they know how to cure inflation. Only incredible luck would produce a soft landing at this point. The Fed is aiming to produce a modest amount of inflation--confident that, if it manages that, it can bring the inflation back down once the economy is out of danger. In the short term, though, I think the risk of inflation has fallen quite a bit, simply because so many people want to hold dollars.

Since the Fed is trying to create some inflation, I don't expect this situation to persist for long--I wouldn't get rid of your inflation hedges--but don't enter into transactions expecting inflation to bail you out, and don't be surprised if we see some of the price hikes of the past few months suddenly reversed.

It's a scary situation, and it's not very comforting to realize that the central bankers are just as scared as we are.

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Thanks for that great explanation of the current situation. I also thought the Fed was insane for lowering rates (last time--not this time), but have since decided they may have actually known what they were doing.

It's good to be reminded of all the interrelationships too. I appreciate your post!

I have been watching the Fed's rate cuts over the last 10 years with concern. It seems like their response to every downturn in the market is to print more money. But since China was pegging their currency to the dollar, now matter how low the dollar fell, it would always be cheaper to import from China.

In 2004-5, when home prices got really out of control, it was obvious to me that there was a serious housing bubble. I thought if the Fed raised interest rates, maybe the housing market would cool down without an economic disaster such as we're now experiencing. They did raise rates a few times, but any time the market dipped, they'd cut rates again. But I'm not an economist. Do you think there is any validity to the idea that the Fed could have done something to deflate the housing bubble before it got so huge?

Greenspan (who no longer looks so clever as he did for most of the past 20 years) decided that there's just no way to know when you're in a bubble until it pops. Further, he decided that bubbles aren't so bad: That it works well enough to just wait for the bubble to pop in its own and then clean up afterwards.

That strategy isn't looking so good just now.

Of course, popping bubles early isn't going to be popular with the people who've invested in whatever was going up. Worse, even if it's not impossible to spot a bubble, it's not trivially easy either. If you just raise rates anytime things seem to be going good, you're sometimes going to squelch perfectly sound business activity.

So, it's not easy, but I think the next generation of central bankers will do better than Greenspan.

... they know what they are doing, a lot of people are putting a lot of confidence in their decisions and if the trust is misplaced then they are going to struggle to regain confidence in the economy. Lets hope they do know and things will all get better sooner rather than later as I am not sure how many people at the bottom end can sustain living on the money they make.

When Greenspan made his infamous irrational exuberance remark, I thought the stock market was out of control and I applauded Greenspan for pointing it out. But the fallout from that remark was so severe that I think it spooked Greenspan because I noticed ever since then that he would never speak negatively about the economy. I wasn't surprised when he ignored the housing bubble. In fact I think he intentionally created it with his rate cuts post-Sept 11. The stock market had dropped considerably and I think he was trying to stimulate the economy through real estate. Many renters decided to buy homes for the first time in 2002 because mortgage rates were at 50 year lows. I was one of those 1st time homebuyers and the low rates were the #1 reason I decided to buy (luckily I sold in 2007 and I had bought a home I could afford in the first place so I did pretty well).

To be fair I absolutely do not think Greeenspan intended to create the economic disaster we're experiencing. But he tried to fix the crash of the tech stock bubble with a housing bubble. I agree with you that it can be hard to spot a bubble and you may do more harm than good by raising interest rates at the wrong time. But if you looked at graphs for home prices it was obvious by 2006 that there was a huge bubble.

I wasn't aware that Greenspan thought letting a bubble burst was as effective as trying to keep it from getting too big. I always learn something new from you!

Moreover, it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity--the very outcome we would be seeking to avoid.

In this one he talks about why housing bubbles are very unlikely (insert wry grin here):

Why do people persist in thinking that the government, the Fed and the central bankers know what they're doing?

They don't. We are in uncharted waters. The government, the Fed and central bankers have lost control and are desperate. They are close to being out of bullets.

With injections of liquidity and the manufacture of dollars out thin air on a scale unknown in history, something will have to give. The result will be inflation. Inflation happens when too many dollars chase too few goods and services.

I think even the central bankers would agree that they're flailing about, trying to find some way to keep things from just melting down.

I just said that I didn't think they were insane (which had pretty much been my position for the past year or so).

Inflation versus depression is, of course, the key. Personally, I don't think your scenario (depression and then inflation) is the most likely; I'm more concerned that we'll have inflation first (wiping out the value of the money) and then a depression (ruining anyone who hasn't already been ruined). If we have the depression first, I think the inflation scenario becomes much less likely. (There was some inflation after the great depression, but not hyperinflation.)

The actual mechanics of what's going on are very interesting. The Fed is creating reserves at a breathtaking pace, but (so far) that has not translated into much growth of the money supply--because the banks have been refusing to lend the money. (And with good reasons--they're broke and so are most other financial institutions.) The result is that there's just no way to know whether we're going to see things tip toward recession or inflation.

My take, looking at the most recent numbers, is that just now we're tipping away from inflation. It could go back that way--I've been expecting it to for months now--but so far it's not.

I don't see where vast amounts of wealth disappeared. When people got sub-prime mortgages to pay for houses that had recently doubled in price, the seller of the house actually received the cash. When the buyer walks away and leaves the bank with a house valued at only 75% more than it's worth, the seller still has the cash.

When commodities prices increased they said they were too volatile to indicate higher inflation; now that they are decreasing they claim that they indicate lower inflation?

The government is cutting rates to keep housing values high and make lending cheap. Since this is the root of the problem, how is this supposed to solve it. Homeopathy?

The thing is, even illusory wealth has an effect on people's spending. Someone who's got a HELOC with $50,000 of available credit, will act as if they could go out and spend that money--different people will act that way to different extents, but in the aggregate, that line of credit is enough like money that it makes a difference.

If that line of credit goes away (because the bank decides that they don't have any equity any more) it won't affect the economy the same as if $50,000 in real money went away, but it does affect the economy.

thanks for the links, Philip. I expect what we'll see in the future depends on who's in charge, and how far off the next bubble forms - by that time people may have forgotten the housing bubble. Or, if the recession lasts for years, people may be so happy for the upturn of a bubble that there will be too much public pressure against even a small contraction.

Having worked in a central bank and having had the chance to talk to some of the senior economists (I'm not an economist) my perceptions changed.

The media seem to put an aura around central bankers as all knowing and powerful. I remember distinctly in the late 90's the fascination with every sentence uttered by Alan Greenspan. I can tell you quite plainly they don't deserve it. They are regular people just like you and me. They make mistakes just like you and me as well.

Let's not forget why we are in this financial mess in the first place. Excessively low interests and the general population's belief that house prices would rise forever. I can tell you there are smart economists with some of the best university degrees who bought property right at the peak.

I don't think central bankers are evil or incompetent. They all believe they are doing the right thing. The trick is to ignore the fluff in the media and focus on yourself.

Get out of debt. Build up savings. Buy assets of value and be mindful of risk.

Yep, central bankers are just people. On average, they're about average. I don't have any expectation that they'll be especially clever or lucky. But sometimes, through luck, cleverness, or simply being the right person in the right place at the right time, you can get above-average results.